Although options trading is extremely popular, the reality is that it is not that straightforward and you have to be pretty tactical to become a successful trader in this space.
The terminologies and processes involved in options trading could be confusing not only for beginners but even for veteran traders as well. But you shouldn’t be worried anymore since you are in the right place as this article provides comprehensive guidance about options trading for beginners including easy-to-understand examples.
If you are interested in options trading or considering jumping on the bandwagon, then this guide will take you through everything that options trading involves, how to go about it, various options trading strategies, and also explain the various terminologies that you will come across as you trade.
Let’s get started by explaining what options trading is.
What Is Options Trading?
As the name suggests, options trading is the trading of options (contracts) that give you the right to sell or buy specific securities on a specific date and at a specific price.
An option is a contract or agreement that is linked to underlying security like a stock. It gives you the right to buy or sell the underlying asset (mostly in bundles of 100) at a predetermined price by a certain pre-specified time.
However, when you buy an option, you do not have to buy or sell the underlying asset since it is not an obligation. You are only given the right to do so by a pre-specified time. If you decide to trade the underlying asset, it is referred to as exercising the option.
If you choose to let an option expire without exercising the option, you lose the ‘premium,’ which is the amount you pay when buying an option. Let’s delve deeper into these terms in the following sections.
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Basic Categories of Options
There are two basic categories of options: call options and put options.
We shall look at what each of these is, how to buy it, and how to exercise it along with a trading example.
What Are Call Options?
A call option gives you the right to buy the underlying security at a predetermined price by a pre-specified time.
The price you pay for buying the underlying asset is called the ‘strike price’ while the deadline date for exercising the option is called the ‘expiration date’.
Call options are normally available in two styles: the American Style and the European Style. The American Style allows you to buy the underlying security at any time before the deadline while the European Style only allows you to buy the underlying security at the expiry date.
Buying a Call Option
If you decide to buy a Call Option, usually just referred to as buying a Call, you pay a premium to purchase particular security (stock or asset) at a set price before the pre-specified time.
You should buy call options if you anticipate that the price of the underlying security (stock or asset) is going to rise before the expiration date.
Let’s say Company A’s stock is currently at $10 per share and you anticipate that the price of the stock will rise. You could buy a call option to buy the stock at the price of $10 (which in this case shall be the strike price of the contract) that expires in let’s say six months for a premium of $1.
Since premiums are charged on a per-share rate, buying 100 shares would cost you $100 as a premium. It is also important to note that different option trading platforms provide a list of strike prices to choose from and it might not be the same as the current price of the stock.
If the price of the stock rises, let’s say to $15, you could exercise your option to buy the 100 shares at the specified strike price of $10; meaning you would pay $1000 for the 100 shares. After exercising the call option, you would then turn around and sell them at $15. In this instance, you would make $1500.
So subtracting the cost of buying the options ($1000) and the premium of $100, your profit will be $400.
Now, let us assume that the price of the stock remains at $10 or drops by the time the option is expiring. In this case, you could let the option expire and your total loss would be the premium of $100 that you paid to buy the call option. The $100 is also termed as the maximum amount that you could lose in the investment.
There is always a breakeven point at which you neither make profit nor loss when buying a call option. In the above example, the breakeven point is $11. If the stock rises to a price that’s between $10 and $11, you could resell the shares to recoup some of your investment and if you exercise the call option at $11, you would recoup the amount you paid as a premium and the amount you pay to exercise the call option.
Another thing that is important to know is that if the stock price rises above the strike price, the contract itself gains intrinsic value, and the price of the premium increases accordingly. It means that you could sell the contract to another investor before the expiration date at a higher price than you bought it for (cost of the premium); meaning you could make a profit. However, you need to look at a variety of factors to know whether to sell the contract or exercise it.
Selling the option (contract) only allows you to make a profit on the premium while exercising allows you to make a profit by selling the underlying security.
What Are Put Options?
A put option gives you the right to sell the underlying security at a predetermined price by a pre-specified time. In a nutshell, while the call option allows you to buy the underlying asset, a put option allows you to sell the underlying asset.
Just like call options, put options also come in two styles, the American style, and the European style. The American style allows you to sell the underlying asset at any time as long as the deadline is not reached while the European style only allows you to sell the underlying asset on the deadline.
Buying a Put Option
This is commonly referred to as ‘buying a put’.
When you decide to buy a put, you will require to pay a premium just like when you buy a call option.
Buying a put is mainly done when you anticipate that the price of the underlying security (e.g. stock) is going to drop. They are similar to shorting a stock although put options can be used to hedge against stock price drops that could hurt your stock portfolio.
Let’s say a company’s stock is trading at $20 and you anticipate that the price of the stock is going to fall. So, you buy a put option with a strike price of $20, a premium of let’s say $2, and an expiration of six months.
The contract will cost you $200 (i.e. premium for purchasing 100 put options).
If the stock price happens to fall to let’s say $15 before the period of six months expires, you can choose to exercise your option and sell the stock at $20.
It is important to note that by exercising the put option you will not earn any profit. Instead, by selling the shares at the price you purchased them, you will have protected your shares from losing value.
If the price of the stock rises instead of falling, the maximum amount of money you would lose is the total premium which amounts to $200.
Looking at the above example, puts option can be considered as insurance for your stock since if the price of the stock falls, you are insured to sell the stock at a higher price and if it rises there is only a fixed cost which is the premium you paid. It doesn’t really matter how much the stock rises.
However, put options can also be used for speculation. You don’t have to own the underlying security to ‘buy a put’. Using the above example, if you bought the put option and the stock price dropped to $15, you could choose to buy the stock at the low price of $15 and then turn around and sell it at the strike price set in the put option contract similar to what we did with the call option).
Purchasing the stock at $15 and selling it at the strike price of $20 would result in a profit of $300 ($2000 for selling 100 shares minus a premium of $200 and $15, which is the cost of buying 100 shares at $15 per share).
Additionally, just like call options, put options can also have an intrinsic value. If the underlying security drops below the strike price, the contract becomes more attractive and the cost of the premium increases accordingly; meaning you can sell the contract to another investor at a higher price to make a profit.
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Why You Should Trade Options
From the above examples, we have seen that options trading can be used to grow your income, hedge against market fluctuations, and also limit the amount of risk resulting from market fluctuations.
In most cases, investors use options trading to complement their stock portfolios. By combining the two, you stand a better chance of earning sustainable income than by choosing to purely trade stocks
For example, if you own a stock and its value decreases, the value of your stock portfolio would certainly decrease. But if you trade options, you could buy a call option to limit the loss you would make in case you anticipated that the stock price is going to rise. On the other hand, you could buy a put option to hedge against the market price drop.
Where Do People Trade Options?
If you are interested and convinced that options trading is the way, then all you have to do is look for an options trading broker.
An options trading broker is a firm that offers options trading services including online platform where you can buy put and call options.
If you are searching for an options broker, you will find that there are many to choose from. Therefore, you should consider several factors before settling on one. Some of the things to consider include:
- Ease of use of their options trading platform.
- The available options trading and research tools on the trading platform.
- The per-contract fee (i.e. premium and commissions).
- Trading strategies allowed.
If you live in the UK for example, just type ‘Options trading UK’ in your search engine and you will get a list of the options trading brokers that offer the service in the United Kingdom. Some of the best options brokers include Robinhood and Ally Invest.
Robinhood offers free-commission options trading and standard zero-commission stock trades. However, it does not offer the level of fundamental research you would find with other options brokers like Alley Invest, Fidelity Investments, and Charles Schwab.
Options Trading Strategy
Keep in mind that there is no one strategy fits all when you are trading options. The strategy will differ from person to person depending on their trading goals and expectations. In this section, we give an overview of the most popular strategies you can rely on.
However, before delving into the different strategies for options trading, it is important to mention that you should do some simple calculations to find the maximum profit you intend to gain, the maximum loss you are willing to forego, and the breakeven point for the number of contract options you wish to trade. You can use an options trading simulator to determine these.
You should also set your goal. Do you want to trade short-term options or long-term options? Are you in options trading for income generation, hedging, or speculation?
Below are some of the most popular strategies for trading options.
1. Covered Call Strategy
This strategy is used for buying a call, especially where you want to generate income or reduce the risk of going long on a particular stock.
In simple words, a covered call refers to a transaction where you hold an equivalent amount of the underlying asset as to the amount involved in the call options. So, you purchase the underlying security as you would normally do and then go ahead to sell (write) a call option on the same shares.
The long position of the underlying security acts as the cover because it means you can deliver the shares if the buyer of the call option chooses to exercise.
2. Married Put Strategy
This strategy is used with put options for limiting losses while also speculating on the market price movements. It is simply used as an insurance policy.
You purchase a security (like a stock) and simultaneously purchase put options for the same number of shares ‘at-the-money’ (at the same price) as that of the stocks you bought. You will therefore have the option to sell your stocks at the strike price in case of a price drop.
3. Bull Call Spread Strategy
This strategy is used with call options and you can use it when going bullish on particular security like stock and expect a moderate rise in the price of the security.
So, you simultaneously buy a call at a specific strike price and sell the same number of call options at a higher strike price. And both call options should have the same expiration date and same underlying security. In short, you place a call options ‘buy’ and ‘sell’.
4. Bear Put Spread Strategy
This is the opposite of the bull call spread strategy. It is used when going bearish on particular security expecting a moderate fall in its price.
In this case, you simultaneously buy put options at a strike price and sell the same number of put options at a lower strike price.
5. Protective Collar Strategy
You can use this strategy if you have already gone long on a particular underlying security. It protects your investment against large losses but also limits huge gains.
To use the protective collar strategy, you create a collar by buying an out-of-the-money put option and simultaneously write (sell) an out-of-the-money call option. The put will protect you in case of a price drop while the call option provides a chance of earning an income if the price rises.
6. Long Straddle Strategy
You can use this strategy if you are not sure about the movement of certain security like stock; so you do not know whether it is likely to move up or down, especially following some strong market news.
7. Long Strangle Strategy
This strategy is similar to the straddle strategy with the only difference being that instead of buying a put and a call at the same strike price, you buy the call and put options at different strike prices but with the same expiration date and same underlying security.
Similar to the straddle strategy, the strangle strategy is used when you think there will be a huge price movement but you are not sure of the direction.
8. Long Call Butterfly Spread Strategy
This strategy uses a combination of the bear spread and the bull spread strategies using call options. Three options used have different strike prices.
However, you should ensure that all the options involved are for the same underlying security and have the same expiration date.
An example is buying one in-the-money call option at a lower strike price and simultaneously selling two at-the-money call options and buying one out-of-the-money call option.
You should use this strategy if you think the security (e.g. stock) will not move considerably before the expiration of the options.
9. Iron Condor Strategy
This strategy combines the bear call spread and bull put spread strategies.
You sell one out-of-the-money put option and buy one out-of-the-money put option of a lower strike price while also selling one out-of-the-money call option and buying one out-of-the-money call option of a higher strike price.
All the options involved should be of the same underlying security and should also have the same expiration date.
10. Iron Butterfly Strategy
This strategy is similar to the butterfly spread strategy, with the only difference being that it uses both puts and calls at the same time instead of just using either of the two as in the case of the butterfly spread strategy.
In this strategy, you sell an at-the-money put option and buy an out-of-the-money put while also selling an at-the-money call and buying an out-of-the-money call. All the options should be of the same underlying security and should have the same expiration date.